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April 16, 2012

Mandatory Auditor Rotation: Will What Goes Around Come Around?

Could there be a plausible explanation why James Doty, chairman of the Public Company Accounting Oversight Board, would promote such a protracted timetable for decision on the notion of mandatory auditor rotation?

It’s been a mystery, ever since the PCAOB’s August 16, 2011 concept release revived this much-discussed and long-discredited idea. Nor was any clarity brought to Doty’s thinking by the parade of 47 witnesses during the two days of hearings on March 21-22.

The comment deadline has been extended, following receipt of a record number of letters, 95% negative, and Doty has announced a travelling road show of further hearings.

One of my good sources, versed in the ways of Washington agency politics, offered as a rationale for Doty’s stalling efforts the growing list of smaller-county regulators who are stumbling toward mandatory rotation.

Why would Doty get behind this array? I’d be reluctant to buy the hypothesis that by postponing long enough, he could claim to fall into line behind an artificially-created “consensus” – which would look less like global leadership from a US regulator than weak-spined passivity.

But consider the hedge in Doty’s reticence – it being likely that the collective short-term experience will collapse in misguided impracticality.

Here is the country list, with their varying and mutually inconsistent deadlines:

Italy – and its nine-year rotation schedule, despite scholarly criticism and even after the 2003 debacle at Parmalat.

South Korea – rotation after seven years, under rules in place since 2006, although the academic research concludes that “mandatory auditor rotation increases the cost for audit firms and clients while having no discernible positive effect on audit quality.”

Brazil – five years, extendible to ten for companies that establish credibly functioning audit committees (here).

India – under the new Companies Bill of 2011, rotation will be imposed after five years for individual practitioners and ten years for audit firms (here and here).

Plus the increasing possibility that instead of requiring rotation, the UK will go instead to either audit engagement re-tendering or “comply and explain” for extended auditor tenure (here).

Taken together, the aggregate GDP of the countries involved approaches that of the United States itself.[1] But such measures would understate the impact of a disparate set of rotation timetables.

That’s because large players in whole industries would have operations in all the affected countries – e.g., the petroleum majors, the large auto and truck manufacturers, the global airlines, and the big banks.

Picture the next decade of rotation-driven challenges to audit committees and chief financial officers – obliged to engage new firms of auditors, from outside the network of their main firm, for significant country-level audits on six or seven different and irreconcilable cycles and deadlines.

Administration of the very basics of engagement performance would be horrifically complex – deployment of replacement firms nearly every year, each with its own culture, personnel and methodology, and the upstreaming of country-level results for global consolidation. And that’s without a thought for the impossibility of achieving uniform standards of quality and execution.

A comparison worth noting is the annual task faced by American major-league baseball, to deploy four-man crews of umpires across a season of 162 games played by thirty teams. That data-management challenge for the “national pastime” has been addressed in recent years by ground-breaking innovations from a university professor specializing in complex scheduling software (here).

For baseball, there are said to be “a host of constraints such as union-mandated vacations and league rules that regulate, for example, coast-to-coast travel and potential overexposure to individual teams.”

Child’s play, by comparison. Putting teams in the field to call balls-and-strikes in the global audit market makes baseball’s difficulty look like Little League.

It could be inferred from the PCAOB’s March hearings that Doty lacks the votes for rotation. So enough frustration and implementation difficulties in foreign jurisdictions would provide him with political cover under which to retreat.

And well he should – but right now, on a well-formed record, and without further delay.

Mandatory auditor rotation is an unambiguously bad idea, unsupported by any evidence of a link between auditor tenure and audit quality. As the growing list of local rotation obligations will soon make clear, it will prove unmanageable for complex global companies.

More important issues confront the issuers and users of financial information – such as the basic content and value of corporate and auditor communications to users, under scrutiny by both the PCAOB and the IAASB. The energy devoted to the misbegotten effort on rotation would be better used elsewhere.

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[1]Data from the International Monetary Fund indicate a global total of $ 78.9 trillion, with the US accounting for $ 15.1 trillion. The five countries add to $ 10.88 trillion, to which the UK would add $ 2.23 trillion.